Certified public accountant engaged in improper professional conduct by recklessly failing to comply with professional standards in connection with his audit of a public company. Held, it is in the public interest to deny accountant the privilege of appearing or practicing before the Commission with the proviso that he may apply for reinstatement after three years.

I.

Barry C. Scutillo, a certified public accountant and partner in the Florida firm of Scutillo & Blake, and the Division of Enforcement appeal from the decision of an administrative law judge. The order for proceedings charged that Scutillo failed to ensure that the 1994 financial statements of Sky Scientific, Inc.("Sky") complied with Generally Accepted Accounting Principles ("GAAP"), and that Scutillo's audit of those financial statements was not conducted in accordance with Generally Accepted Auditing Standards ("GAAS"). More specifically, the order charged that Scutillo engaged in improper professional conduct within the meaning of Rule 102(e)(1)(ii) of our Rules of Practice1 in that he "intentionally, knowingly, or recklessly" failed to comply with professional standards with respect to (1) the valuation of Russian certificates of deposit ("CDs") held by Sky, (2) the failure to record expense incurred by Sky in connection with its issuance of common stock for services, and (3) the valuation of Sky's mining properties.

The law judge found that Scutillo was reckless in connection with his audit of the Russian CDs and the stock expense. He concluded, however, that Scutillo's audit of Sky's mining properties was not shown to be reckless. Scutillo appeals from the first two determinations and the Division from the third. Both parties seek review of the sanction imposed by the law judge, who suspended Scutillo from practice before the Commission for a period of three years. We base our findings on an independent review of the record, except for those findings of the law judge that are not challenged on appeal.

II.

Background

The charges in this case are based on Scutillo's audit of Sky's financial statements for the fiscal year ended February 28, 1994. Sky, with headquarters in Boca Raton, Florida2, was purportedly engaged in the mining and processing of precious metals on properties located in California and Nevada. Its common stock, registered with the Commission under Section 12(g)of the Securities Exchange Act of 19343, was traded over-the-counter and quoted on NASDAQ.

Walter A. Dorow, Jr., Sky's chairman and chief executive officer, and Jerry L. Foster, its chief financial officer4, hired Scutillo to conduct the Sky audit on May 16, 1994, just two weeks before Sky's annual report on Form 10-K was due. Sky obtained an extension of the due date until June 15. However, according to Mark F. Jensen, a Utah accountant whom Scutillo engaged as a concurring reviewer on the basis of Jensen's supposed expertise in auditing mining companies, Scutillo was under "big time pressure" to complete the audit.5

Scutillo was admittedly aware that Sky was a high risk engagement. The company had changed in-house controllers three times in the preceding year, and Scutillo told Jensen that Sky's financial records were "chaotic" and "in a mess." Even more significantly, Scutillo knew that, during the year prior to his hiring, Sky had employed three other auditors in succession. The law judge rejected as not credible Scutillo's testimony to the effect that he did not believe Sky was auditor-shopping. Noting the large number of auditor switches in a short period of time, and the fact that Sky dismissed two auditors shortly after they added going concern qualifications to previously unqualified audit reports, the law judge found that Scutillo was clearly on notice that Dorow fired auditors who did not see things his way.

For the fiscal year ended February 28, 1994, Sky suffered a net loss of $2,936,828. The company had no sales for the year and, at year's end, had total cash of only $3,049. Sky's total assets of about $69.7 million consisted almost entirely of the Russian CDs ($40 million) and Sky's mining properties ($29.5 million). Scutillo's report expressed "substantial doubt about [Sky's] ability to continue as a going concern."

III.

The Russian CDs

A. On February 28,1994, the last day of Sky's fiscal year, a Sky subsidiary purchased $40 million worth of CDs from the Bank Sinektika of Moscow.6 The subsidiary paid for the CDs with 4 million shares of its convertible preferred stock having a face value of $10 per share. As noted above, the CDs constituted more than 50% of Sky's total assets. The purchase agreement was signed by Dorow and, on behalf of the bank, by Hillel Sher. The agreement noted that Sher was a resident of Florida with a South African passport, and stated that he was the bank's "attorney-in-fact."

The terms of the CD transaction were highly unusual. Sky was given the right to rescind the transaction if its auditors concluded that the CDs were "not eligible to appear as an asset at full value on [Sky's] balance sheet." In addition, there was an extremely large disparity between the return on the CDs and the return on the preferred stock. The CD agreement provided that the CDs were to accrue interest at an annual rate of 11.25%. Sky's 1994 Form 10-K stated that the bank would receive dividends on the preferred stock at an annual rate of only 4.25%. However, the CD purchase agreement provided that the dividend rate would be even lower -- 2.5%.

The CD transaction had other striking features. The Russian bank was to deposit the interest due Sky in an escrow account and pay it only when the CDs matured in four years. In addition, the CDs stated on their face that they had been issued for dollar deposits when, as noted, Sky had acquired them in exchange for preferred stock.

Scutillo considered the valuation of the CDs a critical audit area. He was aware that the CD transaction was unusual and that Sky had entered into it on the last day of its fiscal year. Scutillo was concerned as to whether the bank even existed and, if so, whether it had the ability to pay its obligations to Sky. He was also aware that Sky had previously defaulted on dividendpayments on its preferred stock. Moreover, Sky's Form 10-K recited that "[t]he Company has not and is unable to declare dividends as a result of [its] accumulated deficit."

Scutillo's audit of the CD transaction consisted of the following steps:

1. Scutillo examined the CD purchase agreement and the certificates. As noted above, the recitals on the certificates were inconsistent with the manner in which Sky had paid for the CDs, and the purchase agreement differed from the Form 10-K as to the dividend rate on the preferred stock. The record does not show that Scutillo ever sought to resolve these questions. Jensen was concerned about the CDs' recital on their face that Sky had paid for them in cash when the agreement stated that payment was in stock, and he raised the issue with Scutillo. However Scutillo testified that this discrepancy did not cause him any concern. The CD agreement examined by Scutillo also had another deficiency. Although the agreement indicated that Sher's authority as the bank's attorney-in-fact was documented in exhibits to the agreement, no such exhibits were included in Scutillo's work papers, and Scutillo could not recall seeing any such exhibits. He admitted that, aside from the agreement, he never saw a document reflecting that Sher had authority to act on behalf of the bank.

2. Scutillo requested Sky to send confirmation requests to several domestic banks where Sky had small balances, and each such request advised the recipient to return the completed form to Scutillo & Blake at its indicated address. However, Scutillo did not ask that a confirmation request be sent to the Bank Sinektika. According to Scutillo, that request had been sent out prior to his being hired to conduct the Sky audit, and he did not know where or to whom it had been sent. Scutillo did receive a facsimile ("fax") confirmation of the CD transaction that was sent to him from Sky's offices by Sher. The fax's cover sheet was a handwritten note from Sher stating that the original confirmation would be sent to Scutillo as soon as Sher received it from Moscow. Scutillo never received the original confirmation.

The bank's mailing address, telephone number, fax number, and telex number appeared on the face of the CDs. Yet Scutillo never tried to contact the bank to confirm its existence, to verify Sher's authority, to request the missing confirmation, or to obtain any other information. Scutillo stated that, "based on all the other procedures [he] had performed," he did not think any direct contact with the bank was necessary.

3. In an effort to discover whether the Bank Sinektika could pay its obligations to Sky, Scutillo obtained an unaudited financial statement of the bank from either Sky or Sher. There was no indication on the document as to whether or not it had been prepared in accordance with GAAP, and Scutillo did notcontact the bank to determine if the financial statement was genuine. He simply had his staff perform the mathematical computation to convert the amounts on the balance sheet from rubles into dollars. According to Scutillo, he was advised by a banking consultant that Russian banks were not required to have audited financial statements.7 Scutillo stated that he proceeded on the assumptions that the bank existed and that the financial statement was valid, and that, in his view, there is a "presumption . . . that an institution can pay [its] obligations."

4. Scutillo's last audit step was to talk with Richard Greene, Sky's outside counsel. Scutillo documented his conversation with Greene in a memorandum in his work papers which stated as follows:

Barry Scutillo contacted Richard Greene, [Sky's] SEC attorney, to ensure that he was familiar with the CD agreement between [Sky] and [the bank]. Richard advised us that he was not only very familiar with the transaction, but also met with representatives from the [bank] when the agreements were being completed.

Scutillo initially stated that he couldn't recall Greene telling him anything that was not reflected in the memorandum. However, he subsequently claimed that Greene stated that he had participated in negotiating the CD agreement and was aware that Sher was an agent of the bank. Scutillo admitted that Greene said nothing about what, if anything, he had done to verify Sher's authority or the bank's existence.

Greene, whom Scutillo called as a witness, contradicted Scutillo's testimony. Greene stated that he neither negotiated nor prepared the CD agreement. He testified that, at Sky's request, he had a brief introductory meeting with Sher and another bank representative, but that nothing substantive was discussed. According to Greene, he told Scutillo merely that he had met two individuals representing themselves as connected with the bank who "seemed to be very . . . involved in the [CD] transaction." Greene stated that he did not ask these individuals for any identification, and none was given to him.

The law judge rejected the Division's claim that Scutillo's memorandum of his conversation with Greene was a sham. However, the law judge stated that he did so "not because [he had] great faith in the integrity of the [memorandum], but because [he had] doubts about Greene's candor, as well as Scutillo's." The law judge explicitly found Scutillo's testimony with respect to the Russian bank transaction lacking in credibility. We find no reason to disagree with that assessment.

Jensen and his partner Gordon Jones were uncomfortable with the CD transaction, and Jensen told Scutillo that it "did not pass the smell test." Shortly before the deadline for submission of the 10-K report, Scutillo and Jensen called Dorow and told him they were concerned as to whether the CDs should be included in the financial statements, and were considering additional audit steps. Dorow told the auditors that the CDs were real and not to "knock themselves out" with additional audit steps since rescinding the transaction was not an option. Dorow was "extremely anxious" to book the entire $40 million as an asset, and reminded the auditors that Sky's financial statements had to be completed in just a few days. According to Jensen, the conversation with Dorow was a "high pressure situation." Shortly thereafter, after Scutillo had another conversation with Dorow, he told Jensen that, since there was not enough evidence to write the CDs off, it would be arbitrary to take them off the balance sheet.8

B. Failure to Comply with GAAP

Scutillo's audit report represented that Sky's 1994 financial statements presented Sky's financial position fairly in conformity with GAAP. However, as the law judge found, the value of the Russian CDs was materially overstated.

When assets are acquired for other than cash, including assets acquired for stock (as were the CDs), the value to be assigned those assets may be determined by either the fair value of the consideration given or the fair value of the property acquired, whichever is more clearly evident.9 Fair value must be determinable within reasonable limits. It is not so determinable when there are major uncertainties about the realizability of the value to be assigned.10 If neither the fair value of the asset transferred nor the fair value of the asset received in exchange is determinable within reasonable limits, the recorded cost of the asset transferred11 may be theonly available measure of the transaction.12 As set forth below, neither the fair value of the preferred stock exchanged for the CDs nor the fair value of the CDs themselves was determinable within reasonable limits. Thus, since the preferred stock had no recorded cost on Sky's books, the CDs should have been given no value or only a nominal value on Sky's balance sheet.

The value of $10 per share assigned to the preferred stock was wholly arbitrary. There is no evidence that an appraisal of the stock was ever made. The stock did not trade publicly and there was no evidence of its marketability. Sky had minimal cash, no revenues, and was already delinquent in paying dividends on the stock.

As for the CDs, we agree with the law judge and Division expert Leslie Patten that the value of those instruments was too uncertain to record more than a nominal amount on Sky's financial statements. As Patten and Division expert William Holder pointed out, the valuation of the CDs depended in large measure on the Russian bank's ability to pay. Thus, in valuing that asset, Sky was required to evaluate the bank's resources and its capacity to make payment. Neither Sky nor its auditors made such an assessment. As GAAS makes clear, the unaudited financial statement that Sky or Sher gave to Scutillo (which did not disclose the basis for the accounting used in preparing it) did not provide an adequate basis for making the necessary evaluation.13 We agree with the law judge that, without additional audit procedures, the unaudited statement was not competent evidential matter.14 Even Scutillo's expert witness, Peter Burgher, stated that, if he had been engaged to audit the CD transaction, he would have sought "some form of independent confirmation of the existence and size of the bank."

C. Failures to Comply with GAAS

GAAS requires an auditor to exercise due professional care in performing an audit and preparing a report. The auditor must obtain sufficient competent evidential matter to afford a reasonable basis for an opinion with respect to the financialstatements under review.15 He or she must maintain an attitude of professional skepticism.16 Where the auditor determines that there is a significant risk in evaluating a transaction, more or different evidence is required to support that transaction than would be the case in the absence of such risk; for example, a "[t]ransaction that [is] both large and unusual, particularly at year-end."17 If an auditor is in substantial doubt about any assertion of material significance, he or she must not form an opinion until sufficient competent evidential matter has been obtained to remove that doubt. If such evidential matter is not obtained, a qualified opinion or a disclaimer of opinion must be issued.18

Confirmation is undertaken to obtain evidence from third parties about financial statement assertions made by management.19 The auditor should consider requesting confirmation as to the terms of unusual transactions in addition to the amounts involved.20 When evidential matter is obtained from independent sources outside an entity, it provides greater assurance of reliability than that secured solely within the entity.21 An auditor must maintain control over confirmation requests and responses. That means establishing direct communication between the intended recipient of the confirmation request and the auditor in order to minimize the possibility of interception and alteration.22 Confirmation requests should be tailored to specific audit objectives,23 and directed to a party who the auditor believes is knowledgeable about the information to be confirmed.24 Where there is a significant, unusual, year-end transaction that has a material effect on the financial statements, the auditor should exercise a heightened degree of professional skepticism with respect to the requestrecipient's knowledge, motivation, objectivity, and freedom from bias with respect to the audited entity. In such circumstances, the auditor should consider whether there is a sufficient basis for concluding that the confirmation request is being sent to a person from whom the auditor can expect a response that provides meaningful and competent evidence.25 Positive confirmation responses provide audit evidence only when they are received from the persons to whom they were directed.26 Faxed confirmations, which involve risks because of the difficulty in ascertaining the source of the response, may require additional evidence to support their validity.27

In auditing the CD transaction, Scutillo ignored the dictates of GAAS. He failed to maintain control over the confirmation process, and did not obtain sufficient competent evidential matter. He failed to exercise due professional care and failed to exercise heightened professional skepticism when faced with an unusual year-end transaction that materially affected Sky's financial statements.

Scutillo abdicated control over the confirmation process for the CDs. As noted, GAAS requires that direct communication be established with the intended recipient of a confirmation request. Although Scutillo was not even sure that the bank existed, had no evidence of Sher's authority, and was faced with a highly unusual and material year-end transaction, he did not send the bank a confirmation request, a request that could have been tailored, as GAAS provides, to resolve the many questions posed by that transaction. Instead, Scutillo was content to rely on a request purportedly sent by a predecessor accountant although Scutillo did not know where or to whom it had been directed.

Scutillo argues that faxed confirmations are permissible under GAAS, and notes that he received such a fax from Sher. However, as noted, GAAS counsels that caution must be exercised with respect to the validity of faxed confirmation responses. Here the fax came from Sher whose authority to act for the bank had never been established. Moreover, although Scutillo spoke with Sher on the telephone after receiving the fax in order to confirm that Sher had sent it, he did not ask Sher where he had obtained the confirmation. Scutillo never received the promised original confirmation, and his subsequent efforts to contact Sher were unavailing.

Scutillo further contends that, in any event, confirmation is an alternate audit procedure that is unnecessary when theunderlying documents have been examined. We cannot agree that Scutillo's inspection of the underlying documents somehow obviated the need for the assurance provided by a confirmation from the bank. We note, initially, that Scutillo's inspection missed or ignored obvious discrepancies between the documents as to the method of payment and the dividend rate on the preferred stock. Beyond that, confirmation was clearly a necessity in this instance. Given the size, importance, and unusual nature of the CD transaction, Scutillo's admitted doubts about it, and the substantial uncertainties and questions surrounding it, confirmation could not reasonably be eliminated.

As noted above, Scutillo also failed to document a crucial fact. He never obtained competent evidential matter establishing Sher's authority to act for the bank. Scutillo argues that Greene confirmed Sher's authority, and that he (Scutillo) also spoke to Sher who confirmed his own authority to act for the bank. However, Greene did not support Scutillo's claim, nor does the memorandum that Scutillo prepared of his conversation with Greene lend any support to Scutillo's assertion. While Scutillo testified that Greene told him that Sher was an agent of the bank, the law judge found Scutillo's testimony lacking in credibility. In any event, even assuming that Greene made such a statement, Scutillo could not reasonably rely on the unsupported assertion of a third party who had no affiliation with the bank. Nor could he rely on assurances given by Sher himself.

We have already noted that the unaudited bank financial statement given to Scutillo was not, without further audit procedures, competent evidential matter on which Scutillo could rely as establishing the bank's ability to pay. Scutillo claims that Greene confirmed the "bona fides" of the bank and the validity of the CD agreement. There is no support in the record for this assertion.

Ultimately, Scutillo abandoned proper accounting procedures. Rather than obtaining sufficient competent evidence to support the valuation of the CDs, he concluded that they should remain on Sky's balance sheet simply because he did not have enough evidence to remove them.

D. Recklessness

Courts have long defined recklessness as "an extreme departure from the standards of ordinary care, . . . which presents a danger of misleading buyers or sellers that is either known to the [actor] or is so obvious that the actor must have been aware of it."28 We followed that standard prior to the1998 amendment of Rule 102(e),29 and reaffirmed it in adopting that amendment.30

Scutillo argues that he was not reckless. He points out, among other things, that an auditor is not a guarantor against misstatements and is normally entitled to rely on evidence that is persuasive rather than convincing.31 Scutillo asserts that he developed extensive evidential matter as to the legitimacy of the CDs, and that his report not only included a going concern qualification as to Sky but was "clearly footnoted" as to the CDs' credit risk. He further states that he was not a party to and was deceived by the fraud of Sky and its officers, a fraud that was only subsequently uncovered.

Scutillo had neither persuasive evidence nor sufficient competent evidential matter to support the CDs' valuation. His insertion of a going concern qualification in his report did not justify that valuation. Nor did his footnote disclosure. The only credit risk disclosed in the footnotes was the fact that the Bank Sinektika was an "overseas financial institution" that was "not insured by the Federal Deposit Insurance Corporation or any other similar regulatory institution." As the law judge pointed out, Scutillo primarily concerned himself with disclosing the characteristics of the CDs, rather than adjusting their valuation. Thus the financial statements disclosed that the CDs were a non-current, restricted, uninsured asset. However, their $40,000,000 valuation on the balance sheet remained unchanged. Scutillo cannot shift the blame for his actions to Sky. The fraud committed by Sky management did not relieve him of his obligation to conduct a proper audit in accordance with established standards.32 We conclude that Scutillo was reckless.33 He was faced with a highly unusual transactionthat accounted for more than half of Sky's assets, a transaction that had occurred on the last day of Sky's fiscal year. The transaction was economically irrational; a company with no cash, no revenues, and substantial doubt about its continued viability was ostensibly able to acquire $40 million in CDs paying 11.25% annual interest in exchange for preferred stock of dubious value with an annual dividend rate of 2.5%. Yet Scutillo conducted a perfunctory audit that, under the circumstances, was totally inadequate.

Scutillo ignored or missed discrepancies on the face of the documents he assertedly inspected. He never established Sher's authority. He relied on an unaudited financial statement to determine the Russian bank's solvency. He never sent a confirmation request to the bank, much less a request tailored to the need for competent evidential matter. He failed to make a direct inquiry to Moscow even when he did not receive the promised original confirmation and Sher became unavailable.

Although Jensen warned Scutillo that the CD transaction "did not pass the smell test," Scutillo responded to pressure from Dorow and kept the $40 million CD valuation on the balance sheet because, in his view, there was not enough evidence to remove it.

We fully concur with the law judge's assessment of Scutillo's performance, which the law judge summed up as follows:

When the June 15 filing deadline approached, Scutillo surrendered his professional judgment to the demands of his client. He held his nose, closed his eyes, and signed off on the audit report, even though the circumstances surrounding the Russian bank transaction plainly required a qualified opinion or a disclaimer of opinion. This was an egregious refusal to see the obvious or investigate the doubtful by any measure.34

IV.

Unrecorded Expense -- Stock Issued for Services

When a company issues stock in exchange for services, it must (as required by GAAP) record as an expense the quoted market price of the stock less any money that the company receives in exchange.35 In fiscal 1994, Sky issued over 14.7 million shares of common stock.36 Most of the new stock, either registered on Form S-8 or restricted, was issued to pay for the services of consultants and to compensate management and Sky's employees. However, the difference between the stock's market price and the money that was paid by the recipients was not reflected as an expense in Sky's financial statements.

Scutillo was admittedly aware that Sky had issued stock for services. He obtained a schedule from Sky covering all of the common stock that the company had issued during fiscal 1994. The schedule listed each recipient, the number of shares issued to that individual or entity, the dates of issuance, and the money that the recipient had paid. As Scutillo knew from Sky's Form 10-K, the bid price of the company's common stock for that year had ranged from a high of $4.25 per share to a low of $0.47, much higher than the amounts paid by the recipients.

The Division calculated the amount of Sky's unrecorded expense by comparing the closing bid price of Sky's common stock on the day before the stock was issued and the price paid for the stock by the consultant or employee who received it. If the stock in question was restricted, the staff made two additional calculations, one assuming a 25% discount from the bid price and the other a 50% discount. Based on this methodology, the staff determined that the total unrecorded expense ranged between $7.7 million and $10.6 million. We agree with the Division and its experts that this calculation was reasonable.

Scutillo admitted that, in prior audits, he had never overlooked the expense associated with the issuance of stock for services. Thus he should have been aware that he needed to address that issue here. Indeed, the forms he used in connection with the Sky audit alerted him to that need. One checklist item warned the auditor to "disclose discounts on shares." Another directed auditors to consider the "treatment of deferred compensation arising from the sale of capital stock to officers or employees at prices below market." Both checklist items were marked "not applicable." Scutillo reviewed and approved the first such entry, and entered the second one himself.

Scutillo agrees that GAAP requires disclosure of the expense incurred in connection with the issuance of stock for services. He stated that his failure to account for that expense in the Sky audit was an "oversight." He argues, however, that he cannot be faulted for that error, noting that, in another proceeding involving Sky, we subsequently held that some of the stock in question was issued to persons who did not in fact perform any services, and that the market price of Sky's stock during the period in question was manipulated.37 Thus Scutillo asserts that, if he had followed the dictates of GAAP in this instance, he would still have produced inaccurate financial statements.

Our findings of misconduct with respect to Sky and its stock are not determinative of whether Scutillo's professional conduct was proper. His treatment of the stock expense must be judged on the basis of the information that was known to him at the time of his audit, not on the basis of subsequently uncovered information of which he was then unaware.

By omitting the expense resulting from the issuance of stock for services, Sky's financial statements did not comply with GAAP. Scutillo also failed to comply with GAAS in that, in omitting that expense, he failed to exercise due professional care and failed to identify an area of Sky's business that required special consideration.38 We agree with the law judge that Scutillo was reckless. Scutillo knew that Sky had issued huge quantities of stock to employees and consultants at prices substantially below the market price. He had recorded the resulting expense in prior audits in similar circumstances, and his checklist alerted him to the necessity of doing so here. Yet he inexplicably ignored this very substantial item that was material to Sky's reported results.

V.

The Mining Properties

A. At issue in this proceeding is the valuation of three undeveloped gold mining properties that were owned or leased by Sky -- Evergreen, Berry, and Danner.39 As with the Russian CDs, Scutillo viewed the valuation of these properties as a critical audit area. Sky had purchased its interests in Evergreen and Berry for convertible preferred stock with a face value of $5.5 million and $8 million, respectively. It acquired its interest in Danner for preferred stock with a face value of $14 million plus $2 million in promissory notes. Sky purchased its Danner mining claims about a month prior to February 28, 1994, the close of its fiscal year. As Scutillo was aware, Sky was already delinquent on February 28 in paying dividends (in the amount of $445,000) on the preferred stock it had issued to acquire Evergreen and Berry. It was also delinquent on several of its notes.

Sky's mining staff prepared estimates of the ore reserves and related extraction and refining costs for Evergreen, Berry, and Danner. Sky engaged Charles H. Schultz, an engineering geologist, to review those estimates,40 and it used the estimates to prepare earnings projections for its properties, on which it based estimates of their net present value ("NPV").41 The NPV estimates (which were included in the narrative portion of Sky's Form 10-K but not in the audited financial statements) were far higher than the face value of the preferred stock and notes that Sky had issued to acquire the properties.42

Scutillo reviewed and sent to Jensen the valuation materials he received from Sky. Scutillo admittedly lacked the ability to analyze the underlying geological data. He and Jensen paid avisit to three of Sky's mining properties (Berry, Danner and Tallulah) in order to verify their existence. Sky mining employees drove Scutillo and Jensen to the sites, and conducted walking tours in which Jensen's participation was limited due to a physical disability. Although Scutillo thought he saw processing activity at Tallulah (whose valuation is not at issue in this proceeding),43 there was no equipment at Berry or Danner, and no mining operations (or any other activity) being conducted there.

At the conclusion of the tour, Scutillo told Raymond J. Bowkus, Sky's director of mining operations, that he needed additional documentation from Schultz. Scutillo wanted Schultz "to give us comfort" that the extraction cost estimates used in Sky's NPV calculations were within industry standards, and that the proposed mining techniques were reasonable. He "wanted some representation from an expert that the analyses prepared by the company had some validity [with respect] to industry standards."

Schultz responded with three brief identical letters to Dorow, one each for Evergreen, Berry, and Danner. The letters stated that Schultz had examined each property, reviewed all prior reports about it, and made a personal geological and engineer's assessment, evaluating the recovery system and recovery cost estimates which fell within industry standards. The letters did not mention Sky's NPV calculations. However, Scutillo assumed that they referred to those calculations, and felt it unnecessary to contact Schultz to clarify the matter. In fact, neither Scutillo nor Jensen ever spoke to Schultz.

Scutillo never asked Jensen if he had analyzed the underlying data to determine if it supported Schultz's conclusions, and Scutillo did not consider it his responsibility to verify what Schultz had done. Instead, he simply placed his faith in Schultz's purported expertise. Scutillo stated that he relied on Schultz and Sky management with respect to the NPV calculations, and that Schultz's work was "absolutely" critical to his audit conclusions. However, Scutillo had little reason to place great confidence in Schultz.

Scutillo knew nothing about Schultz's professional reputation except what he was told by Sky employees. Schultz provided no references, and Scutillo had no idea if Schultz had ever had any experience in calculating ore reserves or extraction costs. The only investigation Scutillo made was to call the State of California which confirmed that Schultz was a validly licensed engineering geologist. Scutillo admitted that he didnot know what that term meant.44 Division expert Geoffrey Snow explained that an engineering geologist is typically concerned with the construction of such things as highways, dams, and bridge abutments, and may not be competent to calculate ore reserves and mining costs. According to Snow, an economic geologist was far better qualified to make the necessary evaluations.45

Despite Scutillo's asserted confidence in Schultz, he and Jensen had substantial misgivings about the NPV calculations. Scutillo told Jensen that the NPV values were "off the scale," and Jensen stated that the wide disparity between the consideration given for the mining properties and the NPVs gave rise to "a healthy dose of professional skepticism." Scutillo admitted that this disparity was a red flag. In response to a staff question, he acknowledged that he did wonder why "old prospector Don Danner [sold] $155 million worth of gold for . . . $14 million in preferred stock and a couple of million dollars in notes."

There were other obvious problems with the NPV calculations. As Scutillo conceded, the calculations did not take development costs into account, i.e., the capital necessary to get the properties to the stage where mining could begin. Scutillo had recently visited Berry and Danner where he saw no equipment or activity. He was well aware that Sky had no money to pay for start-up expenses which, according to Snow, would amount to millions of dollars. Despite that fact, the NPV calculations assumed that full-scale mining would begin almost immediately. In the case of Evergreen and Berry, the start-up date was assumed to be September 1, 1994.

In addition to the necessary development before mining could begin, there was another problem with Evergreen's purported start-up date. The Form 10-K recited as follows:

Beginning in October 1993, federal law has required that a watershed assessment be performed prior to any new development in a watershed wilderness area. [Sky]...is prepared to begin operations [at Evergreen]when the assessment is completed. The Forest Service estimates this may take from one to three years.

Despite this language, Scutillo stated that he relied on a statement in a Schultz report on Evergreen which, without any reference to the watershed assessment, referred to "one [Evergreen] ore zone which is immediately available for mining." Scutillo never asked Schultz if his report took the watershed assessment into account.

There were additional questions about the mining properties. In his work papers, Scutillo noted that Greene would be asked to confirm (1) Sky's legal title to Berry and Danner, (2) that Sky had a valid leasehold interest in Evergreen, and (3) that "there [were] no uncertainties or other contingencies underlying [Sky's] ownership." In response to Scutillo's inquiry, Greene wrote a letter stating that a Nevada attorney had confirmed that Sky had the legal right to mine Danner, and that there was "a high probability" that Sky could legally mine Berry. As for Evergreen, Greene stated that Sky "appear[ed] to have a legal right to mine the property." Scutillo could not recall any follow-up conversation with Greene to resolve the uncertainties in Greene's letter.

B. Failure to Comply with GAAP

The GAAP principles that applied to the Russian CDs also applied to Sky's mining properties. As noted above, where property of uncertain value is acquired for other property of uncertain value, the value to be assigned the acquired assets may be determined by either the fair value of the property exchanged or the fair value of the property received, whichever is more readily ascertainable. If neither value is determinable within reasonable limits, the recorded cost of the asset transferred may be the only available measure of the transaction.

As noted above, the face amount assigned to Sky's preferred stock was wholly arbitrary. Scutillo admitted that it was impossible to determine the value of that stock. Moreover, the NPV calculations were not a reliable guide to the value of Sky's mining properties. As the law judge stated, these "hypothetical calculations were based on unrealistic assumptions," and the large disparities between the NPVs of the mines and the face amount of the stock and notes issued to acquire them cast further doubt on the NPVs' validity. As Division expert Patten stated, "reliance on a future income stream to calculate present value requires reasonable certainty that such an income stream will occur." No such certainty existed here. Thus, since the values of Sky's stock, notes, and mining properties were not determinable within reasonable limits, and the stock and notes had a zero cost basis, the mining properties should have been given no more than a nominal value on Sky's balance sheet, or at best no more than $18,250, the amount of capitalized expense incurred by Sky with respect to Berry and Danner.

Instead, Evergreen, Berry, and Danner were listed on Sky's balance sheet with a valuation of $29.5 million, the total face amount of the stock and notes issued to acquire them. In reaching this result, Scutillo abandoned GAAP in favor of his own technique, i.e., valuing the mines on the basis of what he considered to be the lower of cost or market. Thus he decided that the NPV valuations were an appropriate method of determining the mines' market value, and that the face amount of the stock and notes could properly be treated as the mines' "cost." Since the mines' "cost" was lower than their "market value," the mines were valued on Sky's balance sheet at the lower figure. Scutillo admitted that, "in essence," his technique gave the parties to a transaction the ability to place their own value on the assets being acquired.

C. Failures to Comply with GAAS

In addition to the standards noted above in connection with Scutillo's valuation of the Russian CDs, GAAS provides that representations from management are not a substitute for the application of auditing procedures necessary to afford a reasonable basis for an auditor's opinion.46 Nor may an auditor simply acquiesce in the opinion of a specialist. An auditor must satisfy himself with respect to the professional qualifications and reputation of the specialist.47 He must consider (1) the reputation and standing of the specialist in the views of his peers and others familiar with his capability or performance, and (2) the relationship, if any, of the specialist to the client.48

Although a specialist with a relationship to the client may be acceptable when circumstances so warrant, an auditor should ordinarily attempt to obtain a specialist who is unrelated to the client. The work of an unrelated specialist will usually providegreater assurance of reliability.49 If the specialist is related to the client, the auditor should consider performing additional procedures with respect to some or all of the specialist's assumptions, methods, or findings to determine that the findings are not unreasonable, or he should engage an outside specialist for that purpose.50

The auditor, the client, and the specialist should have an understanding as to the nature of the work to be performed by the specialist. Preferably, the understanding should be documented and cover, among other things, the objectives and scope of the specialist's work; the specialist's representations as to his relationship with the client; and the methods or assumptions to be used.51

Scutillo could not simply rely on management's NPV calculations, and he ignored the requirements of GAAS with respect to using the work of a specialist. Scutillo had no reasonable basis for relying on Schultz. He never spoke to Schultz, and what he knew of Schultz's reputation came solely from Sky's management and employees. Scutillo never specifically confirmed the nature and scope of Schultz's engagement, never evaluated Schultz's relationship to Sky and its employees, and never really understood the nature of Schultz's work or his methods and assumptions. He did not even know what an engineering geologist was, or that, as indicated by Snow, an economic geologist was much better qualified to make the requisite evaluations.

Scutillo also failed to comply with GAAS in other respects. He clearly failed to maintain a sufficient degree of professional skepticism with respect to the NPV calculations. His analysis did not reflect the great disparity between the NPV calculations and the face amount of the consideration given to acquire the mines; the calculations' failure to account for development costs; Sky's inability to pay for such costs; and the wholly unrealistic start-up dates presumed for Evergreen and Berry, Moreover, he failed to exercise due professional care. He did not resolve the apparent conflict between Evergreen's posited start-up date and the watershed assessment delay noted in the Form 10-K. Nor did he question Greene about his statements that there was only a "high probability" that Sky could legally mine Berry, and that Sky merely "appeared" to have a legal right to mine Evergreen.

D. Recklessness

Although the law judge concluded that the evidence did not show that Scutillo's audit of the mining properties was reckless, he stated that "the issue [was] a close one." We do not agree with the law judge's conclusion, or that the issue is close.

Scutillo admittedly understood that he was required to determine the value of Sky's mining properties, and that the valuation required him to determine either the value of the consideration that Sky gave for the mines or the value of the properties that Sky received in return. As noted above, he acknowledged that it was impossible to determine the value of Sky's preferred stock. With respect to valuing the mines, he told Jensen that the NPV valuations were "off the scale," and admitted that the great disparity between the NPV valuations and the face value of Sky's stock and notes was a warning signal as to the validity of the NPV valuations. Faced with the fact that neither the fair value of the mines nor the fair value of the consideration given for them could be determined within reasonable limits (which absent further auditing procedures required that the mines be recorded at no more than a nominal amount), Scutillo decided to abandon proper auditing principles and adopt his own standard, the lower of cost or market as those terms were defined by him. Accordingly, he treated the "off the scale" NPV valuations as the "market," and the arbitrarily determined face value of Sky's preferred stock and its notes as the "cost." He then valued the mines on Sky's balance sheet at the lower figure. Thus Sky was allowed to place a wholly arbitrary valuation on its mining properties. Under the circumstances, we think it clear that Scutillo was reckless.

Scutillo contends that he was not reckless. He argues that he reasonably relied on the expertise of Jensen, "an experienced auditor of mining properties," who assertedly directed the audit of Sky's mines. The record lends no support to Scutillo's claim that Jensen directed the audit of Sky's mining properties. Nor could Scutillo reasonably rely on Jensen. Scutillo had no reasonable basis for believing that Jensen was experienced in auditing mining properties. When he engaged Jensen, he failed to question him closely about the nature of his experience in mining company audits. In fact, Jensen could recall participating in only one such audit prior to Sky, and in that audit he merely assisted the engagement partner "in certain aspects." Jensen had never acted as engagement partner in a mining company audit, and Scutillo never asked him if he had.

Scutillo further contends that he reasonably relied on Schultz and the reports he prepared, and on Sky and its mining employees. He further notes that he obtained an opinion from Greene assertedly establishing Sky's legal right to mine its properties. As discussed above, Scutillo had no reasonable basis for relying on Schultz. The only check he made of Schultz's qualifications was to determine that Schultz was a licensed engineering geologist. Scutillo never spoke to Schultz, and never explored Schultz's relationship with Sky. Similarly,Scutillo could not reasonably rely on Sky and its employees to provide the necessary support for his independent auditing judgment.52 And Greene's equivocal letter about Sky's legal right to mine its properties raised more questions than it answered.

Scutillo also argues that he was not reckless in valuing the Berry mine. He notes that, as of July 31, 1992, one of Sky's former auditors, BDO Seidman, assigned an $8 million value to Berry (the same figure that Scutillo used), and that Sky subsequently sold the mine for $8.5 million. GAAS provides that information from prior audits must be objectively evaluated in order to determine whether financial statements are free of material misstatement.53 Scutillo never contacted Seidman, never saw the underlying audit records, and had no evidence of what audit procedures Seidman may have used in reviewing Sky's claim of an $8 million value for Berry. Moreover, Scutillo ignores the fact that a subsequent auditor, Weinberg & Company, whose report (as of February 28, 1993) appears in Sky's Form 10-K, gave a zero valuation to Sky's mining properties. While Sky sold the Berry mine to Cerda, Inc. and Inland Pacific Resources, Inc. ("IPR") in late 1994 (after the date of the financial statements at issue), Sky did not receive any cash. It received only IPR convertible preferred stock with a face value of $8.5 million. Scutillo did not know whether IPR's financial statements were audited, whether IPR stock was publicly traded, or whether the stock had any market value.

Scutillo further notes that, on his visit to Sky's Nevada mining properties, he also visited the Springer ore processing facility (which Sky had signed a letter of intent to acquire) in order to verify its existence and confirm Sky's offer. Scutillo asserts that this intended acquisition was significant in that "its consummation, coupled with additional funding," would assertedly have allowed Sky to commence significant mining activities. Scutillo also asks that he be given credit for getting Sky to drop a $16 million valuation for the Bowerman mining property from its balance sheet due to uncertainties as to Sky's title to the property.

We fail to see how these facts diminish Scutillo's recklessness in valuing Evergreen, Berry, and Danner. We note, moreover, that Scutillo was aware from reading Sky's 1994 Form 10-K that Sky's transactions (like the proposed acquisition of the Springer facility) had a tendency to evaporate. In fact, Sky's plan to acquire that facility collapsed after promised funding from a third party failed to materialize.

VI.

Due Process

Scutillo argues that he is being denied due process. He suggests that the Court in Checkosky v. SEC54 invalidated Rule 102(e) as it existed prior to its 1998 amendment. He accordingly argues that the Commission cannot be permitted to utilize a rule "which was not in effect until 1998" to sanction him for conduct that occurred in 1994. Scutillo asserts that, at the time of the audit, he lacked reasonable notice that his actions might subject him to liability.

The order for proceedings for this matter charges Scutillo with improper professional conduct pursuant to unamended Rule 102(e). As we have previously pointed out, that rule has long given us the authority to bring proceedings for intentional, knowing, or reckless misconduct, and it was not invalidated by Checkosky.55 Although the 1998 amendment specified what kind of negligent conduct would constitute improper professional conduct, it introduced nothing new with respect to our longstanding use of the recklessness standard to identify such conduct. That standard is hardly novel, and we have applied it in Rule 102(e) proceedings predating the rule's amendment.56 Scutillo could hardly have been unaware in 1994 that a reckless disregard of professional standards would subject him to liability for improper professional conduct under our rule as then in effect.

VII.

Scutillo argues that the three-year suspension imposed by the law judge is too harsh. He asserts, among other things, thathe cooperated with our staff in its investigation of Sky, that he was "at the mercy" of Sky's fraud, that any auditing failure on his part was an "isolated incident" that occurred many years ago, that his record is otherwise unblemished, and that his firm received favorable peer review reports in 1996 and 1999. The Division urges that Scutillo be permanently barred from practice before the Commission.57

Sky's fraud did not cause Scutillo's auditing deficiencies. In the case of the Russian CDs, he abandoned his independent judgment with respect to a highly suspect transaction and acquiesced in the demands of his client to include the CDs on the balance sheet at a valuation that had no reasonable basis. His failure to record the expense incurred by Sky in issuing stock for services and his deficient valuation of Sky's mining properties are also evidence of his egregious abdication of professional responsibilities. Reckless failures to comply with auditing standards, such as those of Scutillo, "jeopardize the achievement of the objectives of the securities laws and can inflict great damage on public investors."58

As stated above, the law judge concluded that it was not necessary to bar Scutillo from Commission practice. He noted that Scutillo had no prior or subsequent disciplinary history and that, as Scutillo points out, Scutillo's firm received "fully favorable" peer review reports in 1996 and 1999. The law judge also stressed the fact that Scutillo cooperated fully in the Division's investigation of Sky's principals, testifying three times and providing requested documents.

Under all the circumstances, we have determined to deny Scutillo the ability to appear and practice before the Commission provided that, after three years, he may apply to the Commission for reinstatement, upon an appropriate showing. Scutillo may not

resume Commission practice unless and until that application is granted. Our determination recognizes the factors identified by the law judge while assuring that any resumption of practice by Scutillo will be consistent with the public interest.

Admin. Proc. File No. 3-9863

ORDERED that Barry C. Scutillo be, and he hereby is, denied the privilege of appearing or practicing before the Commission with the proviso that, after three years, he may apply to the Commission for reinstatement, upon an appropriate showing.

In 1996, the Commission instituted administrative proceedings against Sky and seventeen other firms and individuals. On the basis of its default, Sky was found to have made false statements to investors and false filings with the Commission, and to have falsified its accounting records. A cease and desist order was issued against the company. Sky Scientific, Inc., Securities Act Rel. No. 7474 (November 7, 1997), 65 SEC Docket 2579. The Commission subsequently issued a full opinion with respect to some of the other respondents in that case. Daniel R. Lehl, Securities Act Rel. No. 8102 (May 17, 2002), 77 SEC Docket 2153, aff'd, No. 02-1228 (D.C. Cir. May 13, 2003).

Dorow and Foster were respondents in the administrative proceeding cited in n.2, supra. On the basis of his default, Dorow was found to have violated registration, antifraud, and reporting provisions of the securities laws. A cease and desist order was entered against him, and he was ordered to disgorge $549,983 plus prejudgment interest. Sky Scientific, Inc., Securities Act Rel. No. 7471 (October 22, 1997), 65 SEC Docket 2278. The law judge's initial decision in that proceeding became final as to Foster. A cease and desist order was entered against him, and he was ordered to disgorge $29,325 plus prejudgment interest. Jerry L. Foster, Securities Exchange Act Rel. No. 41364 (May 4, 1999), 69 SEC Docket 2170.

Jensen was a respondent in this proceeding. Pursuant to an offer of settlement in this and another proceeding, Jensen was found to have engaged in improper professional conduct and barred from practice before the Commission, with the proviso that he may seek reinstatement after three years. Barry C. Scutillo, Exchange Act Rel. No. 44264 (May 4, 2001), 74 SEC Docket 2599.

In the proceeding referred to in note 2, supra, we found that the Russian CDs were counterfeit. Daniel R. Lehl, supra, 77 SEC Docket at 2158, n.13. There is no evidence that Scutillo was aware of that fact.

According to Jensen, Scutillo stated that "he didn't have any proof one way or another whether the bank existed or not and whether the CDs were good or not, and that, because he had no proof that the CDs were bad, he was going to permit them on the balance sheet."

One of the Division's experts, William Holder, referred to this figure as the "carrying amount," which he defined as"the amount at which the consideration given is reflected in the balance sheet in the financial statements of the company immediately prior to the transaction."

The Division excepts to the law judge's determination not to consider the testimony of its expert, William Holder, that Scutillo was reckless. The Division urges us either toconsider Holder's opinion or ignore both his opinion and the contrary opinion of respondent's expert. Scutillo argues that the law judge improperly found him reckless without the benefit of expert testimony to that effect. We have made it clear, however, that neither a law judge nor this Commission requires expert testimony on questions of law. SeeRobert D. Potts, CPA, 53 S.E.C. at 208 and n.56; Pagel, Inc., 48 S.E.C. 223, 230 (1985), aff'd, 803 F.2d 942 (8th Cir. 1986). Thus we have not deemed it necessary to rely on the experts' opinions as to whether Scutillo was reckless.

The Division appeals from a ruling of the law judgeexcluding from evidence the affidavit of a Russian banking official summarizing Russian banking regulations with respect to CDs and concluding that the CDs at issue were bogus. The law judge concluded, among other things, that the affidavit was irrelevant to the issues in this case. We need not reach this question. Its resolution is unnecessary to our determination that Scutillo recklessly engaged in improper professional conduct.

NPV is the difference between the present value of the future net cash receipts of an investment project (discounted at the firm's cost of capital) and the initial cash investment in the project. Kohler's Dictionary for Accountants, 343 (6th ed. 1983).

Economic geologists study the distribution of mineral deposits and the economic considerations involved in their recovery. They also assess the reserves available, and help determine which deposits are economically available to mine. See 12 Encyclopedia Americana, International Edition 453 (1997).

AU § 333.02. SeealsoMontgomery's Auditing, 12th Ed. John Wiley & Sons, 1990 at 47 ("[D]ue care is not exercised if the auditor fails to corroborate representations of client management that are significant to the financial statements...").

AU § 336.05. Our citations and discussion of GAAS standards with respect to using the work of a specialist are based on Statement on Auditing Standards ("SAS") No. 11 (1975). SAS No. 11 has been superseded by SAS No. 73, which contains similar standards and applies to audits of periods ending on or after December 15, 1994.